MNI SOURCES: Fed Leans Toward Keeping "Floor" System For Rates

--Decision On Rates Framework Key To Size of Balance Sheet

--Fed Likely To Keep Floor System

By Pedro da Costa and Jean Yung

     WASHINGTON(MNI) - The Federal Reserve is strongly leaning towards

maintaining its current "floor" framework for setting interest rates rather than

returning to a pre-crisis "corridor" system, although discussions within the

central bank remain active, several senior Fed staffers told MNI.

     When Chairman Jerome Powell took the helm of the central bank in January of

last year, he identified one key source of policy uncertainty that needed to be

addressed quickly: a long-delayed decision on how the Fed would conduct monetary

policy in the wake of its massive bond buys.

     Powell almost immediately ordered staffers across the Federal Reserve

system to begin researching whether the Fed should stick to its post-crisis

"floor system", in which the interest the Fed pays on bank's excess reserves, or

IOER, acts as a floor to the targeted Fed Funds rate at which banks lend to each

other overnight, Fed sources told MNI.

     --FRAMEWORK KEY TO BALANCE SHEET SIZE

     MNI reported earlier this month that the November meeting would likely

focus on honing this discussion, which will help determine the ultimate size of

the Fed's balance sheet as well as the methodology according to which it

conducts monetary policy - what many investors call the plumbing of the

financial system.

     While a decision has not yet been made, and will depend on the views of the

entire Federal Open Market Committee, Fed officials said they are leaning in the

direction of keeping the current "floor" system for several reasons.

     First, operating with abundant reserves has not, despite some initial

concern, led to runaway inflation or hampered the Fed's ability to drain

reserves from the system as it tightens monetary policy. Second, many economists

at the Fed and in markets believe high levels of reserves actually bolster

financial stability by maintaining a pool of safe assets in the system. Third,

the amount of balance sheet trimming required to return to a corridor system

might require going beyond the level of financial tightening the Fed wishes to

conduct.

     --OPTIMAL RESERVES

     Fed officials have broadly converged on a figure around $1 trillion for the

optimal level of bank reserves, a sharp reduction from the current $1.8 trillion

but not as steep as would be needed to return to a system of scarce reserves,

the pre-crisis "corridor system," the sources said. But the final tally is still

under discussion. Banks' excess reserves parked at the Fed peaked at $2.7

trillion in August 2014.

     The downturn prompted a vast expansion of the Fed's balance sheet, which

peaked at $4.5 trillion in 2015 and has been coming down very gradually as the

central bank ceased its earlier policy of reinvesting the proceeds of maturing

bonds on its portfolio, made up primarily of Treasury bonds and agency-backed

mortgage securities.

     Before then, the Fed's operating framework for interest rates operated like

a "corridor" system where the interest on bank reserves was permanently set at

zero, the discount rates created an upper bound, and the official federal funds

rate represented a midpoint.

     This is what Chairman Powell himself had to say on the two options in a

June 2017 speech.

     The "floor system," he said, "is simple to operate and has provided good

control over the federal funds rate. In November 2016, when the Committee

discussed using a floor system as part of its longer-run framework, I was among

those who saw such an approach as 'likely to be relatively simple and efficient

to administer, relatively straightforward to communicate, and effective in

enabling interest rate control across a wide range of circumstances.'"

     He sounded less convinced about the alternative: "Some have advocated a

return to a framework similar to the pre-2007 system, in which the volume of

reserves would likely be far below its present level and the federal funds rate

would be managed by frequent open market operations," Powell said. "This

'corridor' framework remains a feasible option, although, in my view, it may be

less robust over time than a floor system."

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com

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